What if Democrats Hang Tough at Fiscal Cliff?

Any solution to the nation’s fiscal problems remains elusive. Virtually everyone agrees that nothing much will likely be resolved before the election. A lame-duck Congress and president will instead confront a fiscal cliff — when a variety of tax provisions expire at the end of the year and a sequester and debt ceiling loom.

But if the Democrats hang tough, allowing these tax cuts to expire and the sequester to go into effect, they can win this battle. Otherwise, I fear, they are toast.

To be sure, the outcome of this year’s election matters. Still, we’re likely to end up with a divided government and no filibuster-proof majority for either party in the Senate. Let’s assume President Barack Obama is reelected; that Democrats retain, at best, a slim Senate majority; and that Republicans retain the House. In other words, status quo.

Republicans probably would continue arguing for permanently extending all the tax cuts. Democrats then would maintain that this should continue only for the middle class. With a status quo election, however, neither could be enacted.

One way around this stalemate is for both parties to agree to push this to early 2013. But House Speaker John Boehner’s recent threat to use the debt ceiling vote in early 2013 to extract more spending reductions from Democrats, will make them loath to kick it far, if at all. They cannot afford to give up their big stick — to allow all the tax cuts to expire at the end of 2012 or soon after — unless they are willing to call Boehner’s bluff and put the credit of the U.S. government at risk.

It’s an irresponsible threat. But not one a president can ignore.

So the big question is: What are Democrats planning to do? Will they be forced into a compromise that extends all the tax cuts and more spending cuts — in return for an agreement to lift the debt ceiling? Is this the nuclear option that will require Obama and his allies to cave, saving the country from an even worse outcome — an outright default on its debts?

I hope not. Assume for the moment that Democrats allow the tax cuts to expire and the sequester to take place. They wouldn’t argue for this; they would just let it happen after trying hard to find more balanced solutions.

That process would need to start soon. Obama would need to campaign on a job-creating tax package tilted toward the middle class in the short run, combined with something like Bowles-Simpson over the long run.

The White House already has proposed both job creation and deficit-reduction packages. They just haven’t talked about them enough. The package could involve keeping some portions of the Bush tax cuts for the less affluent for a few years and a big loophole closing — like a 15 percent limit on all tax deductions — to begin in, say, 2014 or 2015.

Over a 10-year period, the package would be fiscally responsible but progressive and front-loaded, so as not to harm the economy. It wouldn’t have much chance of happening, but if the president talked about it and Democrats aggressively sought it, it would protect them from later being labeled the party of higher taxes and no jobs.

But the Democrats also would have to display a disciplined willingness to let the tax cuts expire and start the sequester.

This combination would put a large dent in the deficit problem, lowering it by as much as $4 trillion over the decade. It also would defang Boehner’s debt ceiling threat or reveal it for what it is: an attempt to radically reduce the size of government.

This would reset the budget baseline, putting pressure on both parties to come up with offsetting savings if they later wanted to restore a somewhat lower level of taxes or increase spending on their respective priorities.

The big downside to allowing the tax cuts to end and the sequester to happen is the possible effects on the economy — not to mention the political toxicity of higher taxes. Republicans would exploit both to criticize the president and his allies. Democrats might even be forced into some compromises, like tempering the sequester’s cuts to defense or reducing capital gains tax rates. However, such “give backs” from a higher level of revenues would not be popular if they focused on the Pentagon and the wealthy.

Most important, the default would have shifted to the Democrats’ advantage. Changing the default is the key element in this scenario. Any debate about the economy and the deficit would start from a very different place. Deficits would be lower, taxes higher, spending reduced. Yet if the economy began to falter in response, the theory that fiscal austerity creates jobs would be tarnished — creating an opening for new efforts to help the economy.

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